Higher Inflation Target –> Even More Mispriced USTs

A discussion of late has been whether the Fed should raise its inflation target. We think this would be a bad idea. Currently, with a 2% target, the Taylor rule implies the Fed Funds rate should be closer to 2%. With a 3% inflation target, the Taylor rule would imply a Fed Funds rate 50bps lower, of 1.5% (chart below – click to enlarge).

Source: Bloomberg and Variant Perception

This gives the Fed more latitude not to hike rates as inflation moves higher (as it is doing so), and to cut more when – not if – the next recession hits. (In a sign that it is easy to forget recessions are inevitable – perhaps as the last one was so long ago – this is a quote from a WSJ article two weeks ago (emphasis ours): “If another recession hits, it isn’t clear the Fed has the tools available to mend the economy, … .”)

But a 3% inflation target is academic. Inflation of this magnitude is already with us in the US. Services inflation – which is almost 2/3 of the CPI basket – is above 3% (next chart). The Cleveland median CPI is 2.5%. Also, as we discussed in our Tactical of two weeks ago, inflation and bond yields are diverging, and USTs are liable to a sell-off. A higher inflation target would only worsen this very unusual and unsustainable relationship, and leave Treasuries even more precariously overvalued.

Source: Bloomberg and Variant Perception

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